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As leveraged loans gobble up market share, all-important debt cushion grows thin

debt cushion

Two straight years of unprecedented leveraged loan issuance by U.S. corporations and private equity shops – often at the expense of the fixed-rate high yield bond market – has whittled away the subordinated debt tier that can buoy recoveries for investors in cases of default.

Indeed, in 2018, a staggering 79% of U.S. speculative-grade debt issuers last year obtained financing solely from the reliably accommodating syndicated loan market (as opposed to structuring a deal with both loans and bonds). That’s the highest reading since LCD began tracking this data in 2007, and is up from 70% in 2017.

With the recent activity, the share of the currently outstanding leveraged loan universe – $1.15 trillion – comprising a loan-only structure has grown to a record 27%, according to LCD. This evaporation of the subordinated debt cushion matters.

As LCD detailed in its recent recovery study, the bigger the debt cushion in a deal’s capital structure, the better the recoveries for debtholders in cases of default (the cushion is calculated as the share of total debt that is subordinated to the instrument being assessed).

For example, for loans with a very substantial debt cushion (more than 75%), the average discounted recovery was 94%, according to LCD’s analysis of data tracked by LossStats. The lower the cushion, the lower the recovery. A cushion of 26–50% resulted in an average recovery of 73%, for instance.

Of course, recoveries and leveraged loans have been topics of considerable interest lately as loosely structured covenant-lite issuance has taken full root in the loan market, and amid signs that an already aged credit cycle might be coming nearer to an end.

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S&P: Leveraged Loan Recoveries Have Dipped While High Yield Increases

Since 2010, post-default recoveries for U.S. bank debt have often been below their long-term averages, even as bonds have experienced elevated recoveries. Financing conditions have been favorable to highly leveraged companies, with investor demand for leveraged loans supporting growing issuance, tightening spreads, and debt structures with smaller debt cushions and fewer covenant protections.

These favorable conditions have helped support bond recoveries in recent years, as has the prevalence of distressed exchanges, which have tended to benefit the recoveries of bonds rather than loans. These factors could contribute to shrinking recoveries once default rates rise.

In short:

  • Average recovery rates for bank debt (which includes term loans and revolvers) have fallen by two percentage points since 2010, to 72%, as declining recovery rates for second-lien term loans have weighed on term loans overall.
  • In contrast, bonds and notes have experienced above-average recoveries of 51% over the same period as the prevalence of distressed exchanges has supported bond recoveries.
  • The long-term discounted average recovery for bank debt is 73.9%, while bonds and notes have recovered 39.2%, on average.
  • For first-lien term loans, shrinking debt cushions, an increase in covenant-lite, and rising leverage are likely hampering recoveries, and this trend could become more pronounced for recoveries of senior and subordinated debt when the cycle turns.

This analysis is courtesy LCD’s colleagues at S&P Global Fixed Income Research, Diane VazzaNick W. Kraemer, and Evan M. Gunter. The complete analysis is available here.

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Retail investors pour massive $3.3B into US high yield funds/ETFs

U.S. high yield funds and ETFs saw a $3.28 billion inflow of investor cash during the week ended Jan. 16, the largest for the investor segment since December 2016, according to Lipper weekly reporters. The gain follows up on a $1 billion inflow the previous week, bringing the YTD number to a $3.7 billion net inflow.

The activity was evenly split during the week, with funds seeing $1.57 billion of inflows while ETFs saw $1.7 billion.

With the recent surge, the trailing four-week average is a $58.3 million outflow, down considerably from $1 billion a week ago. The change due to market value was plus $475 million.

Assets at U.S. high yield funds now stand at $190.5 billion, of which $41 billion come via ETFs.

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US Leveraged Loan Maturity Wall – Nothing to See Here (until 2023)

With the U.S credit market creaking loudly in December – before rebounding somewhat in January –  leveraged loans once again were thrust into the spotlight, with observers citing loosening underwriting standards and the massive amount of outstandings as areas of special interest.

While those are legitimate concerns, the defaults that can mount as credit cycles deteriorate might have to wait a while this time around.

While the U.S. leveraged loan market now totals some $1.15 trillion in outstanding debt, relatively little of it will come due over the next few years, as borrowers have taken full advance of an accommodating market in 2017 and 2018 to lock in thinly priced debt.

Indeed, this year there’s but a scant $8 billion of U.S. leveraged loans that will mature, according to LCD. That number was roughly $44 billion as of December 2017, though refinancings and repricings reduced that amount dramatically.

Loan maturities step up a bit in 2020, to $25 billion, and to $69 billion in 2021. But it’s not until 2022 when maturities really start to kick in, with $118 billion due. Maturities peak in 2025 – seven years from now, or the length of some credit cycles – when there is $351 billion due.

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Targa Resources Inks $1.5B High Yield Bond Offering

Targa Resources Partners has completed a $1.5 billion, evenly split, two-part offering of senior notes via lead Bank of America Merrill Lynch, sources said. The originally proposed 8.5-year bonds priced at the tight end of talk, while the 10-year maturity, which was added following strong investor demand and upsized by $250 million, priced at the middle of talk. The transaction ended a dry spell for U.S. high-yield issuance, which saw a print-free December 2018 due to an extended wave of market volatility.

Proceeds are earmarked for the full redemption of the issuer’s outstanding 4.125% notes due 2019, and for general partnership purposes, which may include repaying borrowings under its credit facilities or other debt, working capital, and funding growth investments and acquisitions. The issuer had last come to market in April 2018, when it placed $1 billion of 5.875% notes due 2026. Targa Resources Partners LP, a subsidiary of Targa Resources (NYSE: TRGP), owns, operates, acquires, and develops midstream energy assets in the U.S. – Jakema Lewis

Issuer Targa Resources Partners
Ratings BB/Ba3
Amount $750 million
Issue Senior (144A/ w. contingent reg. rights)
Coupon 6.5%
Price 100
Yield 6.5%
Spread T+381
Maturity July 15, 2027
Call non-call 3.5 (first call @ par 75% coupon)
Trade Jan. 10, 2019
Settle Jan. 17, 2019 (T+5)
Joint bookrunners BAML/JEFF/WF/CAPONE/GS/TD
Co-lead managers ABN/BBVA/ING/MUFG/Scotia/SMBC
Co-managers BB&T/BMO/CIBC/Citizens/FifthThird/USBank
Talk 6.625% area
Notes Make-whole  @ T+50; change of control put @ 101; up-to-35% equity claw @ 106.5 until Jan. 15, 2022
Issuer Targa Resources Partners
Ratings BB/Ba3
Amount $750 million
Issue Senior (144A/ w. contingent reg. rights)
Coupon 6.875%
Price 100
Yield 6.875%
Spread T+415
Maturity Jan. 15, 2029
Call non-call 5 (first call @ par +50% coupon)
Trade Jan. 10, 2019
Settle Jan. 17, 2019 (T+5)
Joint bookrunners BAML/JEFF/WF/CAPONE/GS/TD
Co-lead managers ABN/BBVA/ING/MUFG/Scotia/SMBC
Co-managers BB&T/BMO/CIBC/Citizens/FifthThird/USBank
Talk 6.875% area
Notes Upsized from $500 million; up-to-35% equity claw @ 106.875 until Jan. 15, 2022

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Outflows from US Leveraged Loan Funds, ETFs Ease from Recent Peaks

Retail outflows from U.S. loan funds eased to $327 million for the week ended Jan. 9, putting an end to a seven-week run of $1 billion-plus withdrawals, highlighted by a record $3.5 billion outflow two weeks ago, according to Lipper.

With the recent activity, the four-week trailing average moderates to a still-severe $2.37 billion outflow, from $2.9 billion last week.

Mutual funds were behind the outflow this week, with a $464 million withdrawal, while ETFs saw a $137 million net inflow, the first for that segment of the investor base since Dec. 5, according to Lipper weekly reporters.

Of note, the change due to market value was positive $2.2 billion this week, far and away the largest that figure has been. (For the record, U.S. leveraged loans have gained some 2.5% over the past week, according to the S&P/LSTA Loan Index.)

Year to date, U.S. loan funds and ETFs have seen $2.65 billion of outflows, with the current eight-week run of withdrawals totaling $16.1 billion.

Assets at U.S. loan funds now total $90.5 billion, of which $10.7 billion come via ETFs. — Tim Cross

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European Leveraged Loan Market Hits Record Size in 2018

The European leveraged loan market grew by €2.5 billion in December, bringing the asset class to a record  €181 billion at year-end, from €178.5 billion in November, according to LCD’s European Leveraged Loan Index (ELLI).

While issuance of new leveraged loans stalled in December, the Index grew, as a number of November launches allocated and joined the ELLI.

Overall, the size of the invested institutional market increased by 30% during 2018, as tracked by the ELLI, on the back of strong supply of M&A-related loans. Institutional new-issue volume for this purpose rose to a post-crunch high of €57.7 billion last year — up from €41.6 billion in 2017, and above the roughly €30 billion average between 2014 and 2016, according to LCD.

Opportunistic transactions such as refinancings and recaps declined significantly in 2018, to just €19.6 billion, from the €58.5 billion record-high tracked in 2017. Moreover, roughly 70% of the 2018 tally came from the first half of the year. – Marina Lukatsky

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European Leveraged Loans Lose 0.74% in December, Gain 1.41% in 2018

europe loan returns

The fourth quarter of 2018 ended on a much more sour note than it began, as European leveraged loan prices went from holding steady in October to taking a plunge in November, followed by an even bigger sell-off in December.

In the last month of the year the S&P European Leveraged Loan Index (ELLI) lost 0.74%, which is the worst monthly performance in almost three years, following a 0.52% loss in November and a coupon-clipping positive 0.33% return in October.

Despite this decidedly poor showing, the European loan segment outperformed its U.S. counterpart, which returned a scant 0.44% in 2018, after a brutal 2.54% slide in December, according to the S&P/LSTA Index.

European leveraged loans returned 1.41% in 2018, besting not only the U.S. loan segment, but significantly ahead of European high yield bond returns, and equities.

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With 4Q Sell-off, Leveraged Loan Prices See Even Distribution

bid distribution

The late-year selloff in the U.S. leveraged loan market has uprooted a dynamic that has dominated the asset class for most of 2018: Precious few bargains in the trading market, as most debt offered to investors was priced at 100 cents on the dollar, or higher.

Now, after broader economic concerns in December grounded the high-flying market, loan bids are more evenly dispersed across various pricing levels, with some market pros seeing opportunity.

To be sure, loan prices have defied gravity until recently. Even at the end of 2018’s second quarter—following a period of excess supply in market, when the share of par-plus deals fell below 30%—half of the issues comprising the S&P/LSTA Loan Index remained in a lofty 99-to-100 price level. And by the end of September the market had strengthened, with 64% priced over par and 19% at 99-par, according to the Index.

Following the November/December sell-off, however, the pricing distribution resembled a bell curve, with only the 95–96 category accounting for more than 20% of the Index, and the bulk of constituents bid between 95 and 99. Less than 1% of loans belonged to the par-plus bucket, the lowest such share since April 2009.

While there remains concern about the sudden slide, a number of market players note that the newfound pricing distribution can be seen as something approaching normal, compared to an asset class were pretty much every issue is skewed toward par, perhaps indiscriminately.

One CLO manager, for example, deemed the recent market move as a “healthy repricing of risk,” while another said they had been finding better opportunities across the leveraged loan secondary over the past month or so.

CLOs, or collateralized loan obligations, are the biggest investor component of the roughly $1.15 trillion U.S. leveraged loan market (that number excludes revolving credits and amortizing term loans, which are syndicated to banks).

How long this newfound pricing dynamic holds remains to be seen. So far this year U.S. leveraged loans have rebounded 1.21% – a spectacular jump for asset class – though longer-term, market players continue cautious, especially as the prospects of additional interest rate hikes lessen and the effects of the market’s considerable covenant-lite outstandings loom.

This analysis was taken from LCD News stories written by Marina Lukatsky, Andrew Park and Tyler Udland.

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S&P Global Ratings Chops Oil-Price Assumptions Through End of Decade

S&P Global Ratings last week announced cuts to its annual price assumptions for Brent and West Texas Intermediate (WTI) crude oil, providing a sobering counterpoint to news today of reduced supply from OPEC nations.

The new assumptions are for $55/bbl for Brent and $50/bbl for WTI in 2019, respectively, or down $10/bbl from prior assumptions. The agency as well trimmed $5/bbl from its 2020 assumptions, also to $55/bbl and $50/bbl, respectively. Its view for 2021 and beyond is at $55/bbl for both Brent and WTI.

“It was just a few months ago that oil market soothsayers were calling for oil to reach $100/bbl,” S&P Global Ratings stated today. The abrupt reversal from that view—as prognosticators now countenance the potential for low $40/bbl in the near-term—reflects the ongoing trade war and news of China’s economic slowdown, and oversupply exacerbated by shale plays and gaping loopholes to sanctions on Iran’s oil exports.

High-yield energy credits posted strong gains this week from the December lows as crude prices found support on the heels of big trailing losses, and as Saudi Arabia and other OPEC constituents appeared to make quick moves to curtail supply in defense of prices. Bonds backing EnscoCalifornia ResourcesNobleTransocean, and Weatherford International were up 4–6 points this morning from the final trades of 2018.

LCD’s Marty Fridson today noted that October and November’s worst-performing major industry, Energy, finished dead last again in December, with a negative 3.95% return as oil prices tumbled. “In the first nine months of 2018, Energy outperformed the ICE BAML High Yield Index by 1.25 percentage points. Following the disastrous fourth quarter, however, Energy ended the year at –6.37%, versus –2.27% for the overall index,” Fridson noted.

The year’s worst performer, though, was Automotive & Auto Parts, at –8.31%. Healthcare was the strongest performer, with a 1.53% gain for all of 2018. — John Atkins

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